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Summary

A price adjustment clause is typically incorporated into an agreement entered into by non-arm’s-length persons to provide for an adjustment to the transaction price in the event that a third-party such as the Canada Revenue Agency (CRA) or a court of law determines that the fair market value of the transferred property is greater or less than the amount otherwise determined by the parties. A price adjustment clause that meets the requirements stated in this Chapter may prevent the adverse tax consequences that would otherwise result from the application of a number of provisions, such as subsections 15(1), 51(2), 69(1), 74.1(1) and (2), sections 74.2 and 74.3, subsections 74.4(2) and 75(2), paragraph 85(1)(e.2), and subsection 86(2). Consequential adjustments will be made in computing the income of the parties to the agreement when the acquisition price of the transferred property is increased or decreased as a result of the application of an effective price adjustment clause.

The CRA issues income tax folios to provide technical interpretations and positions regarding certain provisions contained in income tax law. Due to their technical nature, folios are used primarily by tax specialists and other individuals who have an interest in tax matters. While the comments in a particular paragraph in a folio may relate to provisions of the law in force at the time they were made, such comments are not a substitute for the law. The reader should, therefore, consider such comments in light of the relevant provisions of the law in force for the particular tax year being considered.

Discussion and interpretation

Using a price adjustment clause

1.1 Where property is transferred in a non–arm's–length transaction, the parties may include a price adjustment clause in the covering agreement or in the terms of the shares issued as consideration for the transferred property. Pursuant to the price adjustment clause the parties agree that if the CRA or a court of law determines that the fair market value (FMV) of the transferred property is greater or less than the price otherwise determined in the agreement, that price will be adjusted to take into account the excess or the shortfall.

Purpose of a price adjustment clause

1.2 The transfer of property for proceeds worth more or less than the FMV of the transferred property might result in an inclusion in the income of the person having acquired the property or in the income of the person having transferred the property pursuant to subsections 15(1), 51(2), 69(1), 74.1(1) and (2), sections 74.2 and 74.3, subsections 74.4(2) and 75(2), paragraph 85(1)(e.2) and subsection 86(2) of the Act. A description of those provisions would be beyond the scope of this Chapter.

1.3 Where a price adjustment clause meets the requirements listed in ¶1.5, the property will be considered to be transferred for FMV consideration and the provisions of the Act listed in ¶1.2 will not result in an income inclusion for the purchaser or the vendor.

1.4 The CRA is only concerned with the valuation of property for purposes of administering the Act and determining the tax consequences. It is neither an arbitrator nor a valuator for the parties.

Requirements governing the recognition of a price adjustment clause

1.5 The CRA will recognize a price adjustment clause in computing the income of all parties provided that all of the following conditions are met:

a) The agreement reflects a bona fide intention of the parties to transfer the property at FMV. When the difference between the FMV determined by the taxpayers with respect to a property and the real FMV is significant, it may indicate that the taxpayers did not make a real effort to determine the FMV of the property. What constitutes a significant difference must be determined on a case–by–case basis.

b) The FMV for the purposes of the price adjustment clause must be determined by a fair and reasonable method. The taxpayer’s reliance on a different valuation method than the one chosen by the CRA and the relative inaccuracy of a FMV determination performed in good faith will not, in and of itself, compromise the effectiveness of the price adjustment clause. The determination does not have to be completed by a valuation expert. The issue as to whether or not the parties have used a fair and reasonable method to determine the FMV of a property is a question that must be resolved in light of a complete examination of all the relevant facts. It is not sufficient to rely upon a generally accepted valuation method. It is also necessary that the valuation method be properly applied having regard to all the circumstances.

c) The parties agree that if the FMV of the transferred property determined by the CRA or a Court of law differs from their valuation, they will use the value determined by the CRA or the Court.

d) The excess or shortfall in price is actually refunded or paid, or a legal liability therefor is adjusted.

1.6 Where the price adjustment clause relates to the issuance of shares in consideration for the transfer of a property, the price adjustment may be implemented in a number of ways, including through a change in the redemption value of the shares, the issuance of a note or a change in the principal amount of the note issued with the shares.

The price adjustment may also be implemented by issuing additional shares or by cancelling issued shares without payment such that the FMV of the shares reflects the adjusted FMV of the property transferred. However, a price adjustment clause providing for the issuance of additional shares or cancellation of issued shares without payment in order to adjust the value of the consideration received carries with it a number of legal and technical difficulties that are best avoided from the perspective of both taxpayers involved and the CRA. For instance, events like the winding–up, reorganization or amalgamation of the issuer of the share might make the future exercise of the price adjustment clause difficult or impossible.

1.7 Where the price adjustment clause relates to the issuance of a note or property other than shares in consideration for the transfer of a property, the adjustment to the price may be implemented in a number of ways, including through a change to the principal amount of the note, the issuance of additional non–share consideration, the cancellation of the note or the return of all or part of the non–share consideration.

Consequences arising from the application of a price adjustment clause

1.8 In recognizing the exercise of a price adjustment clause that meets the conditions listed in ¶1.5 in respect of a transfer of property that is subject to a price adjustment clause, the FMV of the consideration received will be considered to be equivalent to the FMV of the property transferred for purposes of applying subsections 15(1), 51(2), 69(1), 74.1(1) and (2), section 74.2 and 74.3, subsections 74.4(2) and 75(2), paragraph 85(1)(e.2) and subsection 86(2) of the Act. Appropriate adjustments in computing the income of the parties to the agreement to which the price adjustment clause related might have to be made in the year in which the property was transferred.

1.9 If the purchaser has filed returns and claimed capital cost allowances, deductions from income based on cumulative eligible capital, or exploration and development expenses in respect of the property for tax years subsequent to that in which it was transferred, any necessary adjustments will be made in those subsequent years. Likewise, any reserves claimed by the vendor to defer the reporting of income will be adjusted.

Special applications of a price adjustment clause

Shares redeemed before the exercise of a price adjustment clause

1.10 Where the consideration received on the transfer of property to which a price adjustment clause that meets the conditions listed in ¶1.5 is in the form of shares and the shares are redeemed before the price is adjusted as a result of the application of a price adjustment clause and the corporation subsequently makes an additional payment as a consequence for that adjustment, the additional payment to the shareholders whose shares were redeemed will be included in the shareholder's income in the year of receipt under subsection 84(3) of the Act.

Estate freeze

1.11 Where the consideration received on the transfer of property to which a price adjustment clause that meets the conditions listed in ¶1.5 is in the form of shares and the holder of those shares still holds the shares immediately before his or her death, subsection 70(5) of the Act will deem those shares to be disposed of for proceeds of disposition equal to their FMV. If the FMV of the consideration received by the corporation for the issuance of those shares differs from the FMV of the shares, the exercise of the price adjustment clause might have an impact on the determination of the FMV of the shares immediately before the person’s death for purposes of applying subsection 70(5).

Butterfly reorganization

1.12 The existence of a price adjustment clause that meets the conditions listed in ¶1.5 in an agreement that is part of a butterfly reorganization might not prevent the conversion of what would otherwise be a dividend into a capital gain under subsection 55(2) of the Act where the adjusted fair market value of the transferred property does not satisfy the pro rata requirement found in the definition of distribution in subsection 55(1).

Sale of accounts receivable

Application

This updated Chapter, which may be referenced as S4-F3-C1, is effective November 26, 2015.

When it was first published on January 14, 2014, it replaced and cancelled Interpretation Bulletin IT–169, Price Adjustment Clauses.

Any technical updates from the cancelled interpretation bulletin can be viewed in the Chapter History page.

Except as otherwise noted, all statutory references herein are references to the provisions of the Income TaxAct, R.S.C., 1985, c.1 (5th Supp.), as amended and all references to a Regulation are to the Income Tax Regulations, C.R.C., c. 945, as amended.

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A price adjustment clause will be recognized where there was a bona fide intention to transfer at fair market value as determined by a fair and reasonable method, with the price adjustment amount (based on the fair market value as determined by CRA or a court) actually paid (or a legal liability therefor adjusted) (para. 1.5). Where the purchase price is adjusted by issuing or cancelling shares (as opposed to adjusting the shares' redemption amount or adjusting a note), this may result in "a number of legal and technical difficulties" (para. 1.6)

Where shares with a price adjustment clause are redeemed before the adjusting payment is made, the adjusting payment will be included under s. 84(3) in the income of the redeemed shareholders when received (para. 1.10). A price adjustment clause in a butterfly reorganization "might" not prevent s. 55(2) from applying (para. 1.12).

the agreement reflects a bona fide intention of the parties to transfer property at FMV;

the purported FMV is determined by method that is fair and reasonable in the circumstances (which does not necessarily entail using CRA's preferred method, nor engaging a valuation expert);

the parties agree that a CRA or Court valuation, if any, will supersede the price otherwise determined; and

the excess or shortfall is actually refunded or paid, or legal liability therefor is adjusted (para. 1.5).

Price adjustment clauses involving shares may use a number of adjustment mechanisms. CRA non-exhaustively mentions changes in redemption value, the issuance of a note or change in the principle amount of a note, or a change in the number of shares issued - although CRA recommends against using the latter because of inherent legal and technical difficulties (para. 1.6).

the agreement reflects a bona fide intention of the parties to transfer property at FMV;

the purported FMV is determined by method that is fair and reasonable in the circumstances (which does not necessarily entail using CRA's preferred method, nor engaging a valuation expert);

the parties agree that a CRA or Court valuation, if any, will supersede the price otherwise determined; and

the excess or shortfall is actually refunded or paid, or legal liability therefor is adjusted (para. 1.5).

Price adjustment clauses involving shares may use a number of adjustment mechanisms. CRA non-exhaustively mentions changes in redemption value, the issuance of a note or change in the principle amount of a note, or a change in the number of shares issued - although CRA recommends against using the latter because of inherent legal and technical difficulties (para. 1.6).

the agreement reflects a bona fide intention of the parties to transfer property at FMV;

the purported FMV is determined by method that is fair and reasonable in the circumstances (which does not necessarily entail using CRA's preferred method, nor engaging a valuation expert);

the parties agree that a CRA or Court valuation, if any, will supersede the price otherwise determined; and

the excess or shortfall is actually refunded or paid, or legal liability therefor is adjusted (para. 1.5).

Price adjustment clauses involving shares may use a number of adjustment mechanisms. CRA non-exhaustively mentions changes in redemption value, the issuance of a note or change in the principle amount of a note, or a change in the number of shares issued - although CRA recommends against using the latter because of inherent legal and technical difficulties (para. 1.6).

the agreement reflects a bona fide intention of the parties to transfer property at FMV;

the purported FMV is determined by method that is fair and reasonable in the circumstances (which does not necessarily entail using CRA's preferred method, nor engaging a valuation expert);

the parties agree that a CRA or Court valuation, if any, will supersede the price otherwise determined; and

the excess or shortfall is actually refunded or paid, or legal liability therefor is adjusted (para. 1.5).

Price adjustment clauses involving shares may use a number of adjustment mechanisms. CRA non-exhaustively mentions changes in redemption value, the issuance of a note or change in the principle amount of a note, or a change in the number of shares issued - although CRA recommends against using the latter because of inherent legal and technical difficulties (para. 1.6).

the agreement reflects a bona fide intention of the parties to transfer property at FMV;

the purported FMV is determined by method that is fair and reasonable in the circumstances (which does not necessarily entail using CRA's preferred method, nor engaging a valuation expert);

the parties agree that a CRA or Court valuation, if any, will supersede the price otherwise determined; and

the excess or shortfall is actually refunded or paid, or legal liability therefor is adjusted (para. 1.5).

Price adjustment clauses involving shares may use a number of adjustment mechanisms. CRA non-exhaustively mentions changes in redemption value, the issuance of a note or change in the principle amount of a note, or a change in the number of shares issued - although CRA recommends against using the latter because of inherent legal and technical difficulties (para. 1.6).

the agreement reflects a bona fide intention of the parties to transfer property at FMV;

the purported FMV is determined by method that is fair and reasonable in the circumstances (which does not necessarily entail using CRA's preferred method, nor engaging a valuation expert);

the parties agree that a CRA or Court valuation, if any, will supersede the price otherwise determined; and

the excess or shortfall is actually refunded or paid, or legal liability therefor is adjusted (para. 1.5).

Price adjustment clauses involving shares may use a number of adjustment mechanisms. CRA non-exhaustively mentions changes in redemption value, the issuance of a note or change in the principle amount of a note, or a change in the number of shares issued - although CRA recommends against using the latter because of inherent legal and technical difficulties (para. 1.6).

the agreement reflects a bona fide intention of the parties to transfer property at FMV;

the purported FMV is determined by method that is fair and reasonable in the circumstances (which does not necessarily entail using CRA's preferred method, nor engaging a valuation expert);

the parties agree that a CRA or Court valuation, if any, will supersede the price otherwise determined; and

the excess or shortfall is actually refunded or paid, or legal liability therefor is adjusted (para. 1.5).

Price adjustment clauses involving shares may use a number of adjustment mechanisms. CRA non-exhaustively mentions changes in redemption value, the issuance of a note or change in the principal amount of a note, or a change in the number of shares issued - although CRA recommends against using the latter because of inherent legal and technical difficulties (para. 1.6).

the agreement reflects a bona fide intention of the parties to transfer property at FMV;

the purported FMV is determined by method that is fair and reasonable in the circumstances (which does not necessarily entail using CRA's preferred method, nor engaging a valuation expert);

the parties agree that a CRA or Court valuation, if any, will supersede the price otherwise determined; and

the excess or shortfall is actually refunded or paid, or legal liability therefor is adjusted (para. 1.5).

Price adjustment clauses involving shares may use a number of adjustment mechanisms. CRA non-exhaustively mentions changes in redemption value, the issuance of a note or change in the principle amount of a note, or a change in the number of shares issued - although CRA recommends against using the latter because of inherent legal and technical difficulties (para. 1.6).

Where the consideration received on the transfer of property to which a price adjustment clause that meets the conditions listed in ¶1.5 is in the form of shares and the shares are redeemed before the price is adjusted as a result of the application of a price adjustment clause and the corporation subsequently makes an additional payment as a consequence of that adjustment, the additional payment to the shareholders whose shares were redeemed will be included in the shareholder's income in the year of receipt under subsection 84(3) of the Act.

the agreement reflects a bona fide intention of the parties to transfer property at FMV;

the purported FMV is determined by method that is fair and reasonable in the circumstances (which does not necessarily entail using CRA's preferred method, nor engaging a valuation expert);

the parties agree that a CRA or Court valuation, if any, will supersede the price otherwise determined; and

the excess or shortfall is actually refunded or paid, or legal liability therefor is adjusted (para. 1.5).

Price adjustment clauses involving shares may use a number of adjustment mechanisms. CRA non-exhaustively mentions changes in redemption value, the issuance of a note or change in the principle amount of a note, or a change in the number of shares issued - although CRA recommends against using the latter because of inherent legal and technical difficulties (para. 1.6).

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